Equity Compensation – Are Stock Appreciation Rights the Right Tool for You?

Stock Appreciation Rights (SARs) are a commonly misunderstood component of the equity compensation mix. This is probably because each of three distinct variations has been promoted as “the answer” at different times over the past two or three decades. To participants, SARs offer much of the same compensatory rewards and risks as stock options. To companies, these instruments offer both accounting and tax considerations that generally make them a second choice to stock options. Many SAR programs deliver only cash (we will get to that in a minute) so some refer to these as synthetic equity compensation.

A quick history lesson.Before 1988 when Reg-T brought the advent of easy same-day-sale exercises for stock options, “Tandem SARs” were a common element in plans.

SARs are an appreciation-only vehicle.This means that the participant only earns compensation to the extent that the price at the time of exercise is higher than the price when granted. In this respect, they are much like stock options. Unlike stock options, only the gain is delivered.

Stand-alone SARs (or just “SARs”) have two distinct variations.The grant can be settled in either cash or stock that is equivalent to the spread at exercise. Cash settled SARs require variable accounting under US accounting rules. They also fall under IRC 409A as deferred compensation. Stock settled SARs have the same fixed accounting as stock options and are also exempt from 409A (when designed properly.) Given the variable accounting and tax issues why would any company use cash-settled SARs?

As mentioned earlier, cash-settled SARs are a synthetic form of equity.For companies who do not want to or can’t give up any ownership, SARs provide an opportunity to share the growth in the company’s value without providing new shareholders. For types of corporate entities like S-Corps this can allow for broader plan participation that might otherwise be possible. The variable component can become expensive, but in the right situation it may not be that big a deal. The 409A component can also be controlled somewhat by structuring vesting properly. Cash-settled SARs may not be the perfect tool, but often companies are not blessed with a perfect set of circumstances. In these cases, cash-settled SARs can be a better solution than anything else available.

Stock-settled SARs are a way to provide the similar compensation result as stock options without the same level of dilution. In a stock option exercise of 100 shares with an exercise cost of $200 (grant price $20/shr) and a value of $1,000 (current price $10/shr), all 100 shares add to shareholder dilution. In a SAR exercise, you would only deliver 80 shares ($800 gain divided by the current $10 price.) With very large gains, the dilution advantage is negligible, but with small gains the reduced impact on dilution can be substantial. Stock-settled SARs offer additional hurdles in administration and support, but they are a great compensation element in specific cases.

SARs are definitely not a do-it-yourself form of compensation. But, they can be a difference in a market where equity is common, but unavailable to a your company. They may also be an excellent replacement for non-qualified stock options if the circumstances are right. Remember that any SAR program will require some additional communication. You must explain the similarities to other elements and unique differences. Make sure you know why your company chose SARs rather than other types of equity compensation. These reasons may provide real or perceived value to participants who may otherwise be wishing for stock options.

This is part of a series of posts on equity compensation instruments that will run the first Thursday of every month for the foreseeable future. Please reach out to me directly if you have any questions.